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Sunday, November 28, 2010

Oh No, QE2 Might Actually Work!

Lawrence Lindsey is concerned that QE2 might work as intended. He is afraid that if QE2 actually spurs an economic recovery there will be higher interest rates that, in turn, will create a fiscal crisis:

Now suppose quantitative easing is “successful” in the way the Fed intends, taking inflation close to the average 2.4 percent rate of the last two decades and government borrowing costs back to their two-decade average of 5.7 percent. To get an idea of what happens to the budget, assume this transition happens over three years, so that by 2013 interest rates are back to “normal.” This “return to normal” will mean the government’s interest costs will rise to $847 billion by 2015 and $1.15 trillion by 2019

[...]

Interest rates could also rise for a variety of other reasons. Much faster real economic growth could have the same effect. An additional point of real growth for five straight years would help by raising revenue by about $450 billion over five years, but a parallel increase in real rates would raise interest costs by $700 billion over the same period. The higher real rates and larger deficit would likely put a lid on the sustainability of any growth spurt

Lindsey is correct that an economic recovery will raise interest rates. In fact, rising yields will be a sure sign of economic recovery. His concerns, however, about a fiscal crisis seem rather misplaced on several fronts. First, it would be easier to deal with fiscal problems in a growing economy created by QE2 than in a Japan-style economic slump created by an aborted QE2. Second, keeping monetary policy tight by having no QE2 would create other problems that his analysis ignores, like further pressure for trade protectionism. Third, tight monetary policy would increase the likelihood of more fiscal deficits and fiscal problems. Consequently, I will cast my lot with QE2 and pass on the Lindsey prescription of tighter monetary policy.

3 comments:

I think Lindsey was arguming for dramatic fiscal restraint, not against quantitative easing.

It seemed to me, however, that he ignores the impact of higher inflation on tax revenues, while accounting for the impact on nominal interest rates and interest expense. (Perhaps that was included in his budget forecasts.) Only the real growth part helps with tax revenue in his discussion.

The real question is, will QE2 produce a recovery that will boost rates and spur a fiscal crisis, or will it be lackluster and then tax revenues drop precipitating a fiscal crisis which will lead to high rates and destroy and already dismal credit market in the US.

Quantitative easing most certainly will increase political pressures on the Fed. Given the breathtaking manner in which they have departed from their original mission to promote price stability, and the morally dubious effort to "rescue" the economy at the expense of savers and retirees, opprobrium is not only to be expected, but, in my opinion, deserved.Rising interest rates